Tuesday, June 23, 2009

Greed , for the lack of better word , is good

If you are one among those who are very serious about trading, or fascinated by the concept of corporate takeovers then the movie ‘Wall Street’ which released couple of decades ago would be a perfect recipe...

This article is about some of the interesting aspects of finance that I learnt through the movie. The movie revolves around two characters: One, a trader who wants to desperately succeed in life and other a shrewd corporate raider.

‘Gordon Gekko’, the screen name of the corporate raider, was an immediate sensation, and as quoted by the directed it drew inspiration from lot of real life corporate raiders like Carl Ivanch, Porson (who coined the term Leveraged Buyout), and Goldsmith etc. This character won lot of critical acclaims for Michael Douglas and he also won an academy award for the best actor.

Corporate Raider:
It was a term introduced in the 70’s and it was used to describe investors who used to observe some opportunities in a particular company and hence take over that company by becoming the single biggest shareholder.

Once they take over the company they restructure the company – improve its operations, throw away the existing management and bring about a change in the company, thereby sowing the seeds for better profitability in the future years. If this is one form, the other form is to strip off the assets. This is little unfair from the company point of view. They take over the company through huge debt and start paying off the debt by selling off the assets. One variant of this is LBO where the companies with huge cash on their balance sheet are taken over and then the debts are paid off through the cash from the company’s balance sheet itself!!

Mostly such takeovers happen when the market value of the share does not properly reflect the economic value of the assets that the business own. Mostly the inefficiency will be with the top management and their attitude towards running the business. Hence in most of the hostile takeover the first thing that happens after the takeover will be to replace the current management team.

There is one particular scene where Gordon Gekko addresses the shareholders of the Teldar paper which he takes over , sums up the entire essence of management inefficiency, difference between managements interests and shareholders interest, exploitable business opportunities, golden parachutes etc...Here Gordon Gekko delivers the most famous dialogue of the 1980’s ‘Greed, for the lack of better word, is good’. This was a very powerful scene in the movie and I would request you to have a look at it.

Insider Trading:
We speak about market efficiency, rapid information updates etc...But the insider trading that happens big time in the market screws up the entire market efficiency. This has been beautifully portrayed in the movie. The way traders base their trading on insider information, how they artificially increase the price , and after a particular price level how they sell it off(after which the stock price would spiral downwards) are brought out .A real trading floor is brought before our eyes , the way the traders handle client calls , the way they write out slips …,( That’s a million dollar learning that I had today!!)

Life of a Trader:
‘Money will make you do things which you normally don’t do’ …….Life of a trader has been portrayed to be very risky and seems to consist of volatile fortunes. In the movie a trader who would have worked for more than about 25 years with the firm would make a big loss and immediately he would be fired (Mercy does not find a place in the dictionary of the trading house) …”One big loss and you are gone”
At the same time our protagonist who would be doing a lot of insider trading and hence earning surplus profit would be amply rewarded (Our protagonist would be arrested latter for his involvement in the insider trading)...

Big Bosses:
The way Gordon Gekkos character was portrayed was simply awesome.
When our protagonist keeps on telling a lot of info on companies , Gordon Gekko would simply respond “Tell me something that I don’t know” ..The arrogance about his talent would be clearly visible in the characterization. The shrewdness in completing the deals, the very remembrance of hell a lot of info on his head, the quick response to changing situations made me really awestruck at the capabilities of the Big bosses.
Overall I loved watching the movie and 2 hours of my time could not have been better utilized…

Tuesday, June 16, 2009

My dear, do you know how much I ‘value’ you

This intro article on valuation was long due from me. Every time I wanted to write the article, I had something or the other coming up my way and could not take this up..Anyways here it comes finally..

Valuation is like a torch in the dark: Assume you ought to purchase a house …You obviously need to have some base price in mind for that house. How do you derive the price for the house? You tend to think in terms of how much of a rental income this house can garner. You will also add in factors like whether the house is centrally located, whether there are any legal risks associated with the house, do we have water facilities associated with the house etc. So using these factors you might be able to roughly quantify the value of the house. So similar to quantifying the value of the house, the concept of Valuation in finance believes that every single asset can be ‘valued’. But take it with a tinge of caution …It is ‘roughly’.Hence if a Harvard MBA claims that he could value an asset precisely, may be ask him to repeat his course at Harvard!! Valuation involves a lot of uncertainties. In order to value a company, you have to be very comfortable with a particular company, the sector in which it operates, the key risks associated with the business. Hence more often than not it is not the person with significant hold on finance concepts emerges victorious on valuation but rather a person who is very comfortable with the business and the industry succeeds the most.

Keep your egos in check before a Valuation: Valuations are done based on discounted cash flow basis. Discounted cash flow is valuing the future cash flows of the company at the present value. This involves cash flow figure which is going to happen in the future, estimated growth rate for that cash flows, and the risk associated with receiving that cash flows...Man, Every data which has to be used is a future value. I always have the peculiar habit of trying to predict my CGPA half way through my semester. This is an activity which I have done right from my UG days...You know what…I have never come close to what my actual CG finally..There were a lot of factors which was leading to the difference. Either I would have gone terribly wrong in estimating my peers (The concept of Relative Grading) or my Professor would have set a unexpectedly difficult ‘Greek and Latin paper’ to me...Anything could have happened .But I confess I at least deviated 5-10% from my actual CG.But the good thing was I never stopped the habit of calculating it. It always gives me a sense of satisfaction to calculate it and come up with a number and it helped me in altering my preparation strategy for the rest of the semester. Valuation is also something similar …Microsoft beat the expectations of the analyst in 51 out of the 52 quarters during its high growth periods. They came up with a EPS of at least couple of cents above what the analysts predicted …But this did not stop the analysts from predicting the value next time …Valuation is a tool which would help you not to make some irrational decision...Assume CISCO wanted to acquire one of the growing technology companies...For sure the CISCO cannot come up with a 4th decimal digit accuracy of the target. But it helps CISCO in not paying a price way too much beyond the actual price. Hence don’t get upset or get too egoistic when you value a company as you are bound to go wrong.

Markets aren’t the best judge: If you are a believer in market efficiency, come out of the wrong notion that the markets predict the value of the equity of the firm correctly every time new information arrives. In fact market efficiency theory states that ‘New information comes into the market at random fashion and the markets adjust themselves to the information very rapidly” (not correctly).....Hence markets are also not correct every time and you have to be careful about the inefficiency in the market. And this existence of inefficiency in the market is what drives you and me to value the company and find its real worth and to earn abnormal profits out of that equity.

Hope the article threw some bit of insight about Valuations…..

PS: *Some of my critiques claim that my blog has less of technical content but has more of stories and other stuff embedded(like Bollywood , cricket etc) …My reasoning would be simple a) This blog is not to prove my technical prowess in finance . But rather it exists with the purpose of sharing the knowledge of corporate finance to as much people as I could...Currently my readers have been as diverse as my younger sister who has a little knowledge on corporate finance to some Profs, whose lectures have been the inspiration for my blog..Hence I have to take a balanced approach in my articles.

Tuesday, June 9, 2009

CFA Level 1 - All that begins well ends well

A flash back of my preparation during the last three and a half months
June 7, 5 pm: “Stop writing, keep your pens down ...Any further writing will lead to violation of CFA code” …By this time I was quite convinced that my performance in CFA level-1 was couple of notches above what CFA would consider as a par to clear this level.

June 6, 10 pm: With my hands heavily clutched over my head, I was seriously looking into the notes of formulae’s and review material that I had prepared for myself.These notes came in really handy for the last minute preparations. It helped me concentrate on my weak areas. Thanks to Lokesh for providing me with a separate room for my preparation..Amazing hospitality!!

May 25, 10 pm: (After Chennai losing the semifinals).”Fuck...The IPL system is not fair…It should have been an all-league system and damn I have wasted 36 hours watching this bloody IPL …” …Came back to room and took my FSA material….”God….I don’t remember what is an Asset Retirement Obligation”…”55000 at stake…Long way to go…Come on…Scale up”..

May 15, 11 pm: Saikot to me “ whats happening to you??....So serious..You have 25 more days and you have already read the syllabus once completely”..Chill yaar..”You have been very consistent in your study schedule and you will easily crack the paper!!”
May 8 , 3 pm : In the tea shop , having my 5th tea of the day(after bunking the office for the third day in the last 20 days) and breaking my head over the spot rate and forward rate concept...Damn , Kill the mathematicians!!

May 4, 5 pm: Double checking my mail box to make sure that I’m not in the dream world ..”A mail from Prof Aswath Damodaran” wishing me on my birthday and also giving some valuable comments about my blog artcile which compared CSK players and finance…Wow...What better birthday gift I could have asked from my friends..Thanks to Arun,Arvind,Sangeetha and Suren..”On cloud nine …So no CFA preparation for the day”

Apr 25, 3 pm: Reading a blog article by a guy on his CFA December 2008 exam experience..As his blog puts it “CFA level 1 was much more difficult than I thought ... Serious and consistent preparation is the key to success “..Me: God, what’s this idiot telling..I called up my friend who took CFA Level 1 last June and is appearing for Level 2 this time. “You have to read the books…Scheweser materials might not be sufficient..At least I read the whole CFA materials twice”..To myself :Jesus….I’m gone…I’m reading just the Scheweser , that too still left with more than 30% of the portion..”I’m in the middle of nowhere

April 17, 8pm: (In Gurgoan) Mahendiran to me(First day of IPL): “Mumbai Indians are going to be the champions this time..It’s a very strong and balanced team..See the big names in the lineup..Nobody could match them”…For me it was the battle between CFA and CSK...Battle between brain and heart..Brain had to take the back seat..I cannot compromise on CSK matches for any reason!!

Apr 7, 8 pm: God…What are these people telling? …Market research on education sector..Presentation, Excel.And I also have to make the sales pitch…Damn ,This is too much…It’s already 8pm and I’m yet to be done for the day…When will I study for CFA?.
Feb 16th , 5pm : After all the placement debacles of seniors ,to myself “ My dear ..Now that you had a trailer for what could be your final placements scenario, its better you start doing something serious..CFA Level 1 might be a pretty decent value add to your CV ..If not anything, your level 1 experience will help you in gaining good knowledge about the subject…Go ahead

All in all its been a great experience in the last three and a half months of preparation for the exam.. I know for sure I crossed the line well before the ball hit the stumps. Just that the third umpire has to press the green button… which will happen on July 28th!!..Will keep you posted on the updates.

PS: The purpose of this article was two fold a)For my level 2 preparatiobn this will serve as an inspiration to me b) For all those who face difficulty while preparing for level 1 can breath easy after reading this blog because....The syllabus is meant to be tough and will test our nerves